March 7, 2005
by Irwin Stelzer
It isn't easy to know where you are going when you don't even know where you have been. That's the problem facing economists as they try to guess where the U.S. economy is headed. A month ago the government reported that the growth in productivity in the fourth quarter had plummeted to the puny rate of 0.8%. But last week the government revised the puny 0.8% to a more robust 2.1%. That means that unit labor costs, originally estimated to be rising at the inflation-threatening rate of 2.3%, had really risen at the less scary rate of 1.3%.
These new figures, along with the announcement that average hourly wages have risen only moderately, gave Federal Reserve Board Chairman Alan Greenspan support for his program of "measured" increases in interest rates, and forced his more hawkish critics to the sidelines.
But not for long. No sooner had the reassuring productivity data become available than predictions of a quiet period in oil markets were shredded by a confrontation with reality: prices soared above the $55 per barrel mark, putting them over one-third higher than at the end of last year. Worse still, Adnan Shihab-Eldin, acting secretary-general of OPEC, warned that supply interruptions might drive prices to $80.
Now, we know several things about oil markets. One is that the OPEC cartel does not have sufficient excess capacity to cope with short-term spurts in demand such as we are now experiencing as a result of the cold snap that is gripping the U.S. northeast and parts of Europe. Saudi Arabia says it is stepping up drilling for new reserves, but it will be some time before that capacity comes on line.
We also know that OPEC's policy of adjusting its output to prevent inventory build-ups in consuming countries will prevent the build-up of stocks that might provide a buffer against price spikes, and that the cartel has abandoned its old price target of around $25-$30 dollars in favor of one in the $40-$50 range.
Finally, we know that oil prices affect the rate at which the U.S. and world economies can grow. Studies suggest that every $10 increase in the price of oil cuts economic growth by between 0.3 and 0.4 percentage points, with the effect magnified if the increase is rapid. With the economy growing at an annual rate of around 4.0%-4.5%, even a sustained rise in oil prices to, say $60 per barrel, would not slow it down to anything like the snail's pace at which Europe's major economies are expected to grow, unless policymakers repeat the mistakes made during earlier supply crises.
But we do not know whether the recent price spurt was due merely to temporary factors such as the cold spell and fires in three U.S. refineries that drove up petrol prices, the extent to which speculative buying is adding to price pressures, whether OPEC will decide at its next meeting in two weeks to stick to its plans to cut output even if prices remain high, how long it will take the Saudis to ramp up capacity, or at what cost refineries that now can operate only on scarce high-quality, "light" crudes can be adapted to process the cheaper, more abundant, "heavy" crude.
Unless something worse than now seems likely happens in oil markets, or some new terrorist attack materializes, the economy seems headed for a good year. The National Retail Federation reported last week that "Strong sales and traffic last month have brightened the retail picture" after four straight months of decline, and that retailers are predicting that consumers will be "heading to the stores in larger numbers" in the spring. And from the Institute of Supply Management comes the cheering news that both the manufacturing and non-manufacturing sectors continued to grow in February.
Meanwhile, the housing market goes from strength to strength. Despite bad weather in parts of the country, housing starts rose in January by 4.7%. Applications for building permits also rose, suggesting that building activity will continue to race ahead.
And the latest jobs report shows that the jobs market is improving. The economy added 262,000 new jobs in February, bringing the new non-farm job total for the past twelve months to 2.4 million.
All of this may be good news for workers, consumers, and the White House. But it is grist for the mill of Greenspan's critics, who want him to raise interest rates faster. They point out that in February, the Fed's favorite measure of inflation recorded its largest increase in over two years, and that house prices have risen by double digits in the past year. The word "bubble" is once again on their lips.
Nor do revisions in productivity and labor cost data impress these inflation hawks. Although the revised productivity and labor cost data are less threatening than the earlier numbers, both compare unfavorably with earlier periods. The 2.1% growth rate in productivity finally recorded for the fourth quarter of 2004 is well below the 4.4% at which output per worker improved in 2003, or the full-year 2004 figure of 4%. And the 1.3% rise in unit labor costs was well above the increases recorded in 2003 and earlier in 2004.
With housing starts up at the highest level in twenty years, the manufacturing and non-manufacturing sectors expanding, no sign that the federal budget is being brought under control, and the weakening dollar threatening to increase the price of imports and reduce the competitive pressure on domestic manufacturers to keep prices down, the hawks may have a point. But my guess is that Greenspan will continue the "measured pace" at which he is raising rates until he believes that the market signals him that he has found the holy grail of the "neutral" interest rate, the one that neither stimulates nor slows the economy.
A version of this article appeared in The Sunday Times (London).
Irwin Stelzer is a Senior Fellow and Director of Economic Policy Studies for the Hudson Institute. He is also the U.S. economist and political columnist for The Sunday Times (London) and The Courier Mail (Australia), a columnist for The New York Post, and an honorary fellow of the Centre for Socio-Legal Studies for Wolfson College at Oxford University. He is the founder and former president of National Economic Research Associates and a consultant to several U.S. and United Kingdom industries on a variety of commercial and policy issues. He has a doctorate in economics from Cornell University and has taught at institutions such as Cornell, the University of Connecticut, New York University, and Nuffield College, Oxford.
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